Commodity Bonds: A Potential Risk Management Instrument For Capital Constrained Commodity Producers

The commodity-linked bond offers a potential means for producers of primary goods both to raise capital and to hedge against output price risk. Commodity bonds are distinguished from conventional bonds in that their return structure is denominated in quantities of the underlying commodity. Optimal levels of bond issues and commodity production are derived, first for producers whose only source of capital is the revenue raised by issuing bonds, and then for producers who can raise capital either by issuing bonds or by borrowing commercially. The models used are extensions of the standard models of futures market hedging. Relatively less risk averse producers are found to be unwilling to pay the premium for transferring the risk implicit in bond sales, and finance production exclusively through commercials loans. More risk averse producers, however, choose to issue bonds. For such producers, the possibility of issuing commodity bonds leads to levels of output and of producer welfare higher than if conventional loans are the sole source of financing available.